Slow Start, A Glimmer of Potential

If you have any leftovers from the Super Bowl, you could use them to throw Vanguard’s factor ETFs a 5th anniversary party—though, to be honest, there hasn’t been a whole lot to celebrate. Dan and I have been skeptical from day one, and while I remain unconvinced overall, U.S. Value Factor ETF (VFVA) has been piquing my attention lately.

But before putting the value factor strategy under the microscope let’s start at the beginning. And if there’s one thing you should take away when it comes to factor funds, it’s that they are decidedly not index ETFs! These are active strategies. The only guarantee is that no factor outperforms all the time, so if you own one, you better be prepared for runs of both out- and underperformance—much as you should with any investment that isn’t linked directly to an index benchmark.

What are factor funds?

Call it what you want—smart beta, factor investing or even enhanced indexing—the premise behind portfolios designed to mimic specific “factors” in the investment markets is that by picking stocks with certain quantitative characteristics, like a low price-to-earnings ratio or low volatility, you can outperform the market. Not all the time, of course, but over time.

Vanguard has been in the factor game for decades—even if they didn’t call it that. I would argue that SmallCap Index (VSMAX) counts as a factor fund—owning stocks with smaller market capitalizations is a tilt away from the broad market and, hence, a “factor.” Value Index (VVIAX) and Growth Index (VIGAX) could be considered among the oldest factor funds around. It’s also more than reasonable to label Strategic Equity (VSEQX) and Strategic SmallCap Equity (VSTCX) as factor portfolios—actively managed using computers to find “value” in smaller companies. How about Vanguard’s various dividend-oriented index funds? Yup, those are factor funds in my book. And Global Minimum Volatility (VMVFX), launched in 2013, certainly fits the factor mold.

What sets Vanguard’s family of “labeled” factor ETFs apart? Well, in part, it’s that they are only available as ETFs (though U.S. Multifactor is the exception with both an ETF (VFMF) and a mutual fund (VFMFX) version). But more importantly, the big difference is, well, marketing. In fact, Vanguard has webpages dedicated exclusively to their factor ETF suite—one for individual investors and another for advisors.

Since Vanguard views their factor ETFs as a separate category, I’ll do the same here. Though, I’d note that the “old guard” doesn’t exactly make a convincing case for factor investing. Last week, I showed that small cap stocks don’t necessarily beat large cap stocks, even over a period of decades. Or consider that Value Index has trailed Growth Index since their 1992 inceptions—and yet, factor advocates would tell you that cheap (value) stocks outperform expensive (growth) stocks.

So, here goes: Five years ago, Vanguard launched five individual factor ETFs: U.S. Value Factor ETF, U.S. Minimum Volatility Factor ETF (VFMV), U.S. Momentum Factor ETF (VFMO), U.S. Quality Factor ETF (VFQY), and U.S. Liquidity Factor ETF (now liquidated). Additionally, as I mentioned, there is the U.S. Multifactor ETF, which combines the characteristics of the momentum, quality and value factors into one portfolio. (It is not simply the three individual portfolios added together, though.)

Each ETF consists of a portfolio of U.S. stocks with specific characteristics, or factors. These factor portfolios have been shown to outperform the market in the past—at least in backtests and academic papers. The implication, to some extent, is that by buying these factors now, you can outperform the market in the future.

Word of caution

I’m repeating myself, but these are active strategies which will outperform and underperform the market at different times. Which means that even if a factor does outperform over the long run, you’ll have to be patient (or have fortunate timing) to capture that outperformance.

You don’t have to take my word for it. In a May 2017 publication, Equity factor-based investing: A practitioner’s guide, Vanguard warns that ...

factor-based investment performance is highly cyclical and typically inconsistent across different economic and market conditions. To increase the odds of success, investors must be willing and able to endure numerous and potentially extended periods of underperformance relative to the broad market index.

Just to drive the point home, Elroy Dimson (one of the great financial market academics) and his colleagues annually produce the Credit Suisse Global Investment Returns Yearbook, which covers more than 100 years and 23 different countries worth of market and financial data.

When Dimson and his co-authors turned their eyes to factor investing, they concluded that there is ...

long-run evidence, spanning many countries, for the existence of factor premiums. Equally, however, [the Yearbook] shows how volatile factor returns can be on a year-to-year basis, and how factor premiums can remain negative for extended periods.

They also say that “there is no guarantee that factor premiums will persist.” In English, that means you may find that factor funds are hard to live with year in and year out, and in the end, future outperformance is not guaranteed.

Closer to home and to Vanguard, just last week, Barron’s asked Burton Malkiel, former-Vanguard board member and author of A Random Walk Down Wall Street, for his take on factor funds:

I am not a fan—they don’t have zero expense ratios. And I’m skeptical of so-called factor investing. There’s a lot of empirical work on this, but by the time you put these things together and charge the additional expenses involved, they aren’t likely to outperform.

Malkiel’s response centers around expenses, so I wonder if his tune changes when it comes to a Vanguard factor ETF charging just 0.13% (or 0.18 in the case of U.S. Multifactor ETF). That seems like a low hurdle for an active fund to clear. Still …

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